"The world... ravaged... the sun beat down on the carbon stricken rock. Civilisation... a distant memory. Human-robot sex... the norm. Each day, every day, survival and ... how? this-thus."

A not too distant, distant too hot near-future.

Tuesday, 15 June 2010

The Magic of Money

I posted this on an old blog I used to run dealing with current affairs and finance. It's not entirely accurate and it's not even the whole story; however I repost for those who are interested in such things and will want to pursue in greater detail.

A Thumbnail Guide to Money & Banking

"'The Grip of Death' is a literal translation of 'mortgage', when the owner of a house pledges his or her house to another with a handshake...unto death."*

Supposedly, the basic business model of banking, is, they take in people's money as savings, upon which they pay interest (in effect, you, as a saver are loaning your money to the bank); they then loan out your money to other people, for which they charge them interest. The difference between the two rates of interest is the profit (minus overheads, etc.), i.e. the rate they pay on savings - the loans we make to them - is lower than the rate they charge on loans made to the rest of us. Let's take a more detailed look. When, for example, you take on board a debt such as a mortgage loan from a bank, the bank doesn't just simply loan - reallocate - money from other people's savings ... banks almost universally operate on the principle of Fractional Reserve Banking.

From Wikipedia: Fractional-reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all deposits immediately upon demand.

Well, that's how it works in theory. But back to the mortgage you were taking out; let's see what how the fractional reserve principle works in practice. The bank only loans you a tiny fraction of the money it holds, the rest (vast majority) - get this - is simply created out of thin air - the stroke of a computer key. Remember your parents telling you money doesn't grow on trees! No, it apparently floats around the ether in unlimited quantities which only bankers can access! So, not only is the vast majority of your mortgage made up of "magic" money, they're going to charge you interest on it!

However, here's the real bankers' trick, by giving you the loan made of this magic money, for which they are charging a hansom interest fee, they can convert this ersatz (Ersatz is a German word literally meaning substitute or replacement) money into real money! How? The ugly truth for you, it would appear, isn't magical at all. Why? Because you have to work to earn it - make it real; with real sweat and tears!

Before I go on to say why this is not an entirely bad systemin principle(in practice is quite a different proposition) - and before you amass a lynch mob with a view to paying the bank a visit, I want to go back to the quote from Wikipedia, specifically the section, "while maintaining the simultaneous obligation to redeem all deposits immediately upon demand." This is a theoretic obligation. Why? Because banks, via the fractional reserve system, loan out more money than they have in reserve as savings and, crucially, they only loan a tiny fraction of the so-called real money (savings); it's mostly all ersatz. Now if, in the seemingly unlikely event, all those people with savings withdraw their money simultaneously, the bank will need to claw back some of that ersatz money they loaned out tout de suite and, if those debtors cannot pay for some reason or other with real money, there's a problem. And here's where we shall look at an actual scenario, i.e., a non-theoretic instance when something like the obligation to redeem all deposits immediately upon demand occur.This event is called a run on a bank - a bank run.

Wikipedia again: A bank run (also known as a run on the bank) occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent. As a bank run progresses, it generates its own momentum, in a kind of self-fulfilling prophecy: as more people withdraw their deposits, the likelihood of default increases, and this encourages further withdrawals. This can destabilize the bank to the point where it faces bankruptcy.

Here's where it gets interesting - if you'll pardon the pun. Let's go back to your mortgage, now the money the bank loaned you is, presumably, to pay someone else back for the purchase of their property. What does this someone else do with the money "you've" paid them? Most likely, the sellers put some or all of it in their bank (which could be the same bank as yours or another). Let's suppose you are both in the same bank. How does the bank treat the money which it loaned to you, now it comes back to them as a deposit by the seller? As if it were all real money! That is, as if you (the person who bought the house) had made it real by paying it all off to the bank! Now, according to fractional reserve banking, the bank can count that deposit as part of its reserves upon which it can make other loans! Can you see the problem? There's a danger that banks can hollow themselves, their reserves, out. This becomes especially clear when you consider the net interaction of banks. If the economy is growing, them the country should be able to turn this ersatz money into real money because of increased productivity, etc. During an economic downturn, the ability to turn ersatz money into real money becomes problematic. Now, if you haven't overstretched as a country, i.e. allowed the creation of ersatz money to go unchecked and saved nothing for a rainy day, there's a danger that you could undergo a nationwide bank run - a run on the entire financial system. Like if you loose your job, can't find another soon enough, fail to make enough mortgage payments, you are in danger of losing "your" home (it's not legally yours until you have paid the loan principle and all interest charges thereupon).

Remember, civilisations, like individuals, flourish and die.

That's the downside, but what are the benefits of this fractional reserve system? With responsible oversight and planning, the benefits are potentially enormous (we've just seen the how the dangers are potentially enormous). Let's imagine you're an entrepreneur who has invested a device that can improve people's everyday lives (something like a washing machine before there were such things). This device could improve lives because its use will free up their time for other things - work, play, spending time with the family or even provide them with some much needed rest. Sounds all very good; so what's the snag? You can only produce ten of these items a week in your tiny workshop, but demand for them is several fold. Whilst you make a profit, it's not at a fast enough rate to reinvest back into production, more staff better machine tools, etc., that would be needed to meet demand. What you need is a factory fully-fitted for mass production.The sales are there to justify it, only you don't have the money upfront to pay for it. If only you could somehow capture the profits from those future sales in order to build it! Here enters the "miracle" time machine of fractional reserve banking! The bank will allow you to borrow against these future "earnings" by pretending the money already exists. You can see how useful such facility is, and can be, for the nation as a whole, which, via the publically owned central bank, can and does the very same thing to build roads, hospitals, pay social security, and all the other social services and infrastructure; they do this because they believe the future tax revenues will be there to pay for it (due to these social improvements it is believe the nations productivity will increase and, therefore, the amount of tax that can be extracted. Conversely, in harsher economic times, when private banks are no longer making loans, the nation, via its central bank, can use the promise of future tax receipts, in better times, to act as "lender of last resort". So, in effect, the central bank - not the private banking sector - is the ultimate buck-stopwith respect to: maintaining the simultaneous obligation to redeem all deposits immediately upon demand."Use of such a facility carries with it great social, as well as individual, responsibility. After all, "the lender of last" resort is also another name for the taxpayer and the planet's natural resources.

Now you are ready to enter the mystery school that is: "The Magic Of Compound Interest."

What has ended is the idea that “the magic of compound interest” can make economies rich without having to work and without industry. I hope we have seen the end of derivatives formulae seeking to make money by playing in a zero-sum game. A debt overhang always ends either in foreclosure of the debtor’s property, or in a debt annulment to preserve the economy’s overall freedom and equity.